Monetary Economics

Lecture 1

Content

- Functions financial system: Book 1, chapter 1.

- Money: definition and functions: Book chapter 2.
- Advised reading: book chapter 3.

Functions financial system -> ‘a financial system should facilitate an efficient allocation of
financial resources.
1. facilitate transactions via a payment system
2. funds for investments (enable the pooling of funds)
3. transfer money where most needed/ most efficient
4. risk management (can manage them but you cannot eliminate them)
5. should generate prices. (you base your decision on prices) (decision based on relative prices)
6. prices reduce information asymmetries; a well function financial function reduces information
asymmetry.

The environment
-> central bank, central position in market economy (supervises banks, help liquidate banks, has
mayor role in the economy) (in Europe central bank more important than UK or us, because of
political decision etc, slow political decision making)
-> non-bank financial institutions.
-> in background (rest of the world) (buying/ celling/ trading etc) (most important parts)

Surplus and deficit households

Surplus households (savers or investors)
-> positive savings ratio (could be low- or high-income households, their save on a cash flow basis)
Deficit household
-> (spend more than income, for high income, spend a lot on a house for example) (or for company,
when having big investment for couple of million/ bil)

Financing the economy

Direct financing: -> direct cashflow
- companies borrow direct from investor or savers
- credit unions: companies directly lend/borrow from each other
- investors buying shares
- family
Indirect financing: -> finance through intermediary
-

Advantages and disadvantages of direct financing

Direct financing
advantages:
- no extra margin necessary (extra cost)
- direct relation saver/investors and households
disadvantages:
- no transformation of risks
- liquidity risk
- credit risk
- concentration risk
- information overload (want to know what’s going on with money so need to follow op)
Advantages and disadvantages of indirect financing
Indirect financing
advantages:
- risk (liquidity; credit)
- transformation of size;
disadvantages:
- surplus households receive lower interest rates than borrower pays
- difference is income intermediary (fees, interest margins)
examples

indirect financing via banks; where risks concentrate

bank removes all the risks (credit; market; liquidity; operational; interest rate). However, price risk is
still yours.

Indirect finance: banks versus other intermediaries

Banks:
*advantages for clients:
-savings are very liquid (so when bankrupt, even when bankrupted probably get money back)

What have we learned so far

- know functions financial system + understand why they’re important
- concepts direct/indirect finance, differences, pro/cons.
- role intermediaries indirect finance + why banks special kind intermediaries in sense that they
attract many risks
- understand risks not created by banks, but present in the system. Every bank is full of risks and
manage them centrally and remove risks from clients.
Money and money standards
Definition of money
Money is anything that, within a certain community, is generally accepted as medium of exchange,
unit of account or store of value.

- Certain community (money here is not accepted anywhere else, dollar, euro, bitcoin, rupee,
etc). (bitcoin is also a community, that could accept bitcoin as money) (linden dollar;
computer game, made avatar, buy/build houses, banks started to buy that on second life; is
still present as a community, 2 mln, you can pay with it at second life).
 money based on general acceptance. (not accepted anymore, becomes valueless)
- functions of money: unit of account (relative prices expressed in money) ; store of value
(save for future) ; medium of exchange ; also borrow (more difficult with bitcoin, say
mortgage with bitcoin)

- material money does not matter (metal, stone, paper)

- intrinsic value not part of this definition
- anything for sale can be bought with money (undifferentiated purchasing power)

core elements that define money: general acceptance; medium of exchange; unit of account;
store of value

 banks note Zimbabwe; 100 000 000 000 000 (highest denomination ever, hyperinflated
money, you can but half a bread with it) (they didn’t want to accept it anymore, system
completely collapsed).

 Germany 1929; starting point national socialism; 50 000 000 000; only printed on one side;
other side blank (to save money, print on the other side when changed)

Money promotes economic efficiency (medium of exchange)

- use of money reduces search costs; reduces the number of necessary transactions; promotes
specialization and the division of labour.
-> money is the lubricant that allows the economy to run more smoothly.
-> ‘’go back to being barter and no money’ they either: don’t like wealth or economic freedom.

Criteria for successful money (cash)

- easily standardized
- widely accepted
- easily divisible into smaller parts (creating change)
- easy to carry
- it must not ‘deteriorate’ quickly: material deterioration (grain) ; economic deterioration (inflation)
-> these are criteria, not always need to be fulfilled.

Money promotes economic efficiency (unit of account)

- reduces number price relationships
- easier to compare value of things (it measures value)
- without money: n(n-1)/2 price relationships
- With money: (n-1) price relationships

Money functions as a store of value

- money not unique as store of value: bond, stocks, land, etc -> they all function as a store of wealth
- money is highly liquid; can buy/sell with it, value is stable
- money is most liquid asset of all (because it is also a medium of exchange)
- value other asset classes also measure in money.

The value of money: substance does not matter (summarized most important things)
- Value money nothing to do with the material.
- Intrinsic value usually completely irrelevant (also status of legal tender irrelevant)
- Money has value if general accepted by the public.
- Economic value = ratio between amount money in circulation and amount of tradable goods
and services in the economy
- Amount of money had influence on financial stability (important to regulate supply/amount
to maintain price stability).

Oldest money standard.

- tobacco standard (in America; British colonists), starting to grow tobacco; like smoking, have good
and bad tobacco; bad money drives out good money; worst tobacco was in circulation and good
tobacco was smoked. Stored in central house and got certificate for quality of your tobacco. -> one of
the early central banks (functioned more than 2 centuries)
- gold: only 40 years or something, the gold standard; important for international standard, not for
day-to-day transaction, start of international globalization
- shells; Asia/ Africa, very sustainable, difference size/collars,

Commercial banks create money

- all deposit money is created by a commercial bank
- but: you too create and destroy money (lend money of bank; create pay back to bank; destroy)
- small country, annual basis, millions of transactions that influence composition of money supply.
- every individual transaction between bank and client had by definition impact on the size,
composition, and/or allocation of the money supply.

Measurement of money
- M = Mc + Mg = money owned by public
- the relevant amount of money (M) is the amount in circulation: ready cash in circulation (Mc) and
the money in the current accounts held at the banks (deposit money, Mg).
- not part of M: money owned by gov and reserves of banks at the CB.
- ‘’near money’’ (highly liquid) = financial assets that are themselves not money, but that can be
changed into money at very short notice (viz. savings deposits)

Measurement of money: monetary aggregates (know definitions by heart)

- M0 = monetary base: Total amount of cash + bank reserves held at CB (all components of MO
are direct liabilities of the CB)
- M1: amount ready cash in circulation + amount money held at banks as current accounts
(demand deposits)
- M2: M1 + savings deposits
 - M3: M2 + liquid investments (short term bonds, money market funds)

- Some more information

What have we learned about money?

- definition + components money
- origin of value of money, in which circumstances money loses value
- concepts intrinsic value, legal tender, and general acceptance
-

The international monetary system

- gold standard: 1816-1936 (with some interruptions)
- system of bretten woods: dollar like to gold;
- Europe:
- today: dollar most important currency (almost all currencies link to dollar, euro, or a currency
basket)

Lecture 2
Gold standard

 England 1816 went to gold standard -> most followed in 1870 (Netherlands in 1875).
(England worlds engine, like china today)
 Classic gold standard:
- Full money = gold content determines value
- exchange rate = relative gold content
 Gold standard:
- all money (coins, paper) covered by gold
- Central banks guarantee convertibility of money into gold -> minting: turning peoples gold
into coins -> individuals also did this and get part of the gold for themselves -> first gold coins
fully gold -> eventually only fraction of coin gold (rest was iron/copper).
- Central role for Pounding Sterling.
 1914: system collapsed (start WW-I), high inflation all over Europe during war, after war
efforts to restore the GS (at pre-world standard, so needed deflation to go back to old
standard), largely unsuccessful (depressions, long deflation in england), system ended in
1930. 1931 England when off golden standard -> central bank lost lot of money.

 Most important about this period was not that is was based on gold but that there were
fixed policy rules. Deficit of money with another country, pay back in gold, decrease money
supply in own country, downward pressure price, restore international competitiveness.
 gold was randomly found in a country and had nothing to do with the economic
development of that time.
  gold based money supply was not able to grow in line with economic activity (one of the
important conditions for monetary stability).

 debate 2 schools of thought in England (currency school & … ): one school won, money
just defined as coins,

Advantages of GS

 Automatic brake on growth of money supply

 Psychological value of gold
 Useful international anchor (all currency linked to each other, first period globalization,
countries investing in each other)
 Automatic mechanisms for rebalancing international imbalances (countries in conflict with
each other while central banks were still cooperating).
 Automatic policy rules (see also monetary policy)

Disadvantages of GS

 Gold supply is small, inelastic and unpredictable

 Trade-off between gold price and other prices. A stabilization of the price of gold (which lies
at the core of the GS) makes other prices more volatile
- oversupply of gold  general inflation
- Scarcity of gold  general deflation
 In a world with a large gross asset and liability positions between agents such huge swings
result in drastic redistributions of income and wealth.
 GS not suitable for a modern economy.

Evolution of the GS

 Beginning system was metal-based

 Gradual increase of fiduciairy money  gold core standard
 Central banks held gold themselves, but it was more profitable to invest in central-backed
securities of other central banks  gold exchange standard.
 Gold doesn’t yield, securities do.

 Dutch central banks went bankrupted bc of currency speculation

The Bretton Woods System

 Learned form GS, Should be less speculatable, less deflationary

 Established in 1944
 Other currencies pegged at the US dollar with fixed, bit adjustable parities
 Dollar pegged to gold at 35 per troy ounce
  Establishment International monetary fund (IMF) -> borrow money to stabalize
 Establishment of world bank -> now more
 3th mechanism -> now called the world trade organization (WTO): overlooks international
trade, if trade is fare.

The privileges of having a reserve currency

 American companies bought a lot of European countries etc, all bought in dollars, mayor
privilege in the US.
 They set the monetary policy of the world (macroeconomic stabilization)
 …
 …
 Disadvantage: global reserve currency is often overvalued  competitive position of anchor
country deteriorates.

The US trade balance and current account (graph)

- trade deficit 2016-2020

Triffin dilemma

 Tension in the system; world needs more dollars, best way to do that is US deficit
 US saving deficit results in growing dollar supply, but also in an increasing foreign debt (in
dollars)
 As dollar supply > gold stock confidence in US dollar may decline.
 A structural saving deficit undermines …
 …

The end of Bretton woods

 Deterioration of US balance of payments

 Strong growth of us FDI and investments in foreign securities
 Strong
 Other currencies tried to change their dollar holdings into gold
  Us
 Total demise of BW in 1973

Graph

Problems with the dollar standard of today

 Exorbitant privilege: no limit US on borrowing when dollar is worlds currency standard

 No automatic brake money creation
 US responsible global financial stability
 Dollar increasinglen instable due to deteriorating us financial strength
 Surplus countries hold huge reserves in a currency that is bound to lose value in a substantial
way.

US savinf deficit graph

Alternative: back to gold?

 Postivive aspects gold standard:

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 Negative aspects gold standards:
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 The reality
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Is a global currency standard necessary?

 World markets will always look for a global standard

- commodity pricing
- vehicle currency
- trade currency
 Any successor would be weak from the start.
 My conclusion: a global standard is a good thing, but should not be based on the currency of
an individual country. The SDR is a proper candidate. In reality, we have to do with the US-
dollar.
 Example -> political power, US sanction policies have to agree, otherwise punished (from a
commercial point of view).
 China also want their currency to be world currency -> are very far -> Europe not, euro
stagnating over 20 years, not stable.
Enter Libra/Diem -> first called libra now called diem (not on exam)

 Libra: ‘’a simple global currency and a financial infrastructure that empowers billions of
people’’.
- low volatility cryptocurrency, but not bitcoin-look-alike
- trump not for this idea -> looses international advantage of dollar
- a decentralized blockchan
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The consequences

A primer on exchange rates

 Nominal exchange rate (e) = price of one currency in terms of another currency.
- one euro today = €1.20 dollar
 Real exchange rate (q) = price of a domestic good or service in terms of a foreign good or
service.
- q = e * (p / pf) -> p = domestic price level, pf = foreign price level.

 Real vs norminal appreciation:

- nominal appreciation =
- nominal depreciation =
- real appreciation
- real depreciation
 but ultimately it is the change in real effective …

 The effective exchange rate -> distribution of the international trade transactions (graph)

In china increased very strongly -> they say that china keeps their exchange rate too low -> not right
conclusion because over time the effective exchange rate has increased quite strongly making china
relatively more expensive.
-> which also teaches you that it not only the price level determines a competitive position but also
what you would produce.
-> for example, the Netherlands (discussion about wage costs), competitive position is productivity,
quality of the product, and not competing on price.
-> Germany example ->

The eurozone: one exchange rate, many REERs, -> graph

- European countries -> big differences -> different history

Purchasing power parity (PPP)

 Ppp = prices of identical goods should be the same when expressed In the same currency
- e * P = pf
 The ‘PPP exchange rate’ is the nominal exchange rate at which PPP holds: e = Pt/P
 PPP good correction factor for international comparisons. Tells you something about
relative wealth levels. Income levels corrected for purchasing power.

What have you learned about exchange rates?

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Introduction to banking
‘’ a bank is a financial institution where you can borrow money only if uou can prove you don’t need
it ‘’ -> Bob hope (comedian)

Learning goals
- what banks do
- functions
-understanding risks
- importance of supervision
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- concepts of liquidity, solvency and profitability

(Stopped at 18.06, second part lecture)